DZS Inc (DZSI) 2006 Q3 法說會逐字稿

Good day, and welcome to the third quarter 2006 Zhone Technologies Inc. conference call. I'm Cammie, and I will be your coordinator for today. At this time, all participants are in a listen-only mode. We will be facilitating a question-and-answer session toward the end of the conference. [OPERATOR INSTRUCTIONS]. As a reminder, this conference is being recorded for replay purposes.

I would now like to introduce Susie Choy, Director of Investor Relations. Please proceed.

Thank you, operator. Hello, and welcome to the third quarter 2006 Zhone Technologies, Incorporated conference call. I'm Susie Choy, Zhone's Director of Investor Relations.

The purpose of this call is to discuss Zhone's third quarter 2006 financial results as reported in our earnings release which was distributed over Business Wire at the close of market today and has been posted on our web site at www.Zhone.com. I'm here today with Mory Ejabat, Zhone's Chairman and Chief Executive Officer; as well as Kirk Misaka, Zhone's Chief Financial Officer. Mory will begin by discussing the results of the third quarter and providing some insight into the future and long-term strategy for the Company.

Following Mory's comments, Kirk will discuss Zhone's financial results for the third quarter and provide guidance for the next quarter. We conclude with questions-and-answers. As a reminder, this conference is being recorded for replay purposes and will be available for approximately one week. The dial-in instructions for the replay are available on our press release issued today. An audio webcast replay will also be available online at www.Zhone.com following the call.

As you know, during the course of the discussion today, we will be making forward-looking statements, including those relating to projections of profitability, earnings, increased revenue, improved margins, reduced operating expenses, or other financial items. The anticipated growth and trends in our business, product lines or key markets, the capital spending environments and the migration of customers and potential customers to newer technologies, Zhone's market position and statements that express our plans, objective, and strategies for future operations. We would like to caution you that actual results could differ materially from those contemplated by the forward-looking statements.

We refer you to the risk factors contained in our SEC filings available at www.sec.gov, including our annual report on Form 10K for the year ended December 31st, 2005, and our quarterly reports on Form 10Q for the quarters ended March 31st, 2006, and June 30th, 2006. We would like to caution you not to place undue reliance on any forward-looking statements which speak only as of the date on which they are made, and we undertake no obligation to update any forward-looking statements.

During the course of this call, we will also make reference to pro forma EBITDA, gross margins excluding inventory write-offs, and operating expenses excluding impairment charges which are additional non-GAAP measures we believe are appropriate to enhance an overall understanding of past financial performance and prospects for the future. These adjustments to our GAAP results are made with the intent of providing greater transparency to supplemental information used by management in its financial and operational decision-making.

These non-GAAP results are among the primary indicators that management uses as a basis for making operating decisions because they provide meaningful supplemental information regarding our operational performance, and they facilitate management's internal comparisons to the Company's historical operating results and comparisons to competitors' operating results. The presentation of this additional information is not meant to be considered in isolation or as a substitute for measures of financial performance prepared in accordance with GAAP. We have provided GAAP reconciliation information for pro forma EBITDA within the press release, which as previously mentioned has been posted on our web site at www.Zhone.com.

With those comments in mind, I would now like to introduce Mory Ejabat, Zhone's Chairman and Chief Executive Officer. Mory?

Thank you, Susie. Good afternoon, and thank you for joining us today for our third quarter 2006 earnings call.

First, I will provide you with some additional information with respect to the third quarter, but then, more importantly, I want to focus on the future and the long-term strategy of the Company. As previously announced, our revenue for the third quarter was substantially below expectations, primarily due to the weakness in our international business. In particular, we experienced the effect of fluctuation in the buying patterns of our largest customers in Middle East and Latin American and a greater than expected seasonal slow down in Europe.

Due to this weakness, our SLMS revenue also declined sequentially, which is particularly disappointing after five consecutive quarters of strong growth in both our international and SLMS businesses. Despite this temporary setback, we expect our revenue to rebound over the next few quarters with the continuing customer wins and expansion from our existing customer base of over 600 customers. Our primary product line of single line multi service products decreased sequentially quarter-over-quarter. As I mentioned, this decrease was primarily attributable to weakness in our international business. Several of our large international customers in Europe and Middle East delayed orders as they evaluate which network architecture and technology path to pursue.

Many carriers are at their crossroad in their evaluation of the next generation network solution, especially with the introduction of numerous new technologies that make their evaluation more complex. As carriers make their technology decision, we expect our revenue to rebound over the next few quarters. In addition to the delays caused by this technology decision, we also saw a couple of our significant international customers in Central and Latin America push out their CapEx spending to next quarter. For these customers, we expect our revenue to rebound in the fourth quarter.

Kirk will provide more details on our financials later, so let me spend a few minutes discussing the future and long-term strategy of the Company. Although the last two quarters have been below expectations, we continue to believe that we have the right strategy for the Company. That strategy included 12 acquisitions over the past six years, which enabled us to quickly develop our technology, expand our customer base and build scale, all of which we believe are critical to competing effectively in our industry. Having built our business to its current level, we no longer plan to rely on acquisition to grow further.

Instead, we plan to grow as our current customer base of 600-plus customers begin migration to next generation technologies. We anticipate that our customers will increase their spending as they search for ways to increase bandwidth, using our EtherXtend technologies or by migrating from copper- to fiber-based networks. These customers will also convert their TDM and ATM networks to capitalize on the benefit of a more flexible IP-based architecture. They will also be expanding their networks to provide multi-service offering of voice, data and video.

Although most of our growth will come from existing customers, it will also grow as our telephone carriers and cable operators recognize the benefit of our solutions. We have been adding 13 to 24 new customers every quarter over the last year and expect to continue to increase market share through our next generation technologies. With that growth, our primary near term goal is to get to quarterly profitability which we expect to accomplish by the end of 2007.

We will continue to invest in research and development to enhance our product offering with more new product and additional functionality that better allow our customers to offer high bandwidth VoIP or IPTV and broadband services. From a customer perspective, we will continue our focus on international growth markets such as Middle East, South Asia, Eastern Europe, and Central and Latin America. Domestically, we will continue to expand our customer base of tier 2 and tier 3 telephone carriers.

During the third quarter we maintained our broad base of service provider customers with sales into each of our worldwide sales regions. Zhone continued to win significant new business for its products with shipments to 18 new customers. Last quarter, we also announced the Hungary manufacturing facility of Communication Test Design, Inc., also known as CTDI, was selected to perform manufacturing and assembly for some of Zhone's single line multi-service product.

That integration of CTDI into our processes was completed towards the end of the third quarter. Although we saw some immediate cost benefit during the third quarter, we expect to see even greater cost saving during the fourth quarter, which will lead to improved margins. Zhone's growing international customer base will also enjoy accelerated delivery [to us from four-class] manufacturer.

In summary, we will continue to focus on having a broad base of products throughout this VoIP, IPTV and broadband. Our single line multi-service architecture continues to be the right strategy as carriers migrate from a TDM network to an IP-based network, as copper lines are replaced by fiber lines and as single services are being replace by bonded multiple services. We are well positioned to take advantage of the market growth in VoIP, IPTV and broadband, and believe our best days lies ahead of us.

Now I would like to turn the call to Kirk to take you through our financial performance and guidance. Kirk?

Thanks, Mory.

Today, Zhone announced financial results for the third quarter of 2006. In our press release, traditional comparison for the third quarters of 2006 and 2005 is presented alongside a comparison to the second quarter of 2006. As you will recall, the fourth quarter of 2005 was the first full quarter reflecting the impact of our acquisition of Paradyne, which closed on September 1st. Since the second quarter results are more comparable to this quarter, we will spend most of our discussion today focusing on the sequential comparison. Although any comparison to the third quarter of 2005 has limited value, we will be glad to answer any specific questions about Q3 2005 results during the Q&A session. With that background, let's begin with an overview of revenue.

Our revenue for the third quarter of 2006 was 43.1 million which was slightly above our revised guidance range of 41 to 43 million. Our single line multi-service product line declined sequentially from 35.3 million in the second quarter to 23.6 million in the third quarter of 2006. This sequential quarterly decline in our SLMS product revenue was due to the weaker than expected international sales that Mory mentioned and otherwise follows five consecutive quarters of strong growth. Also as Mory mentioned, we added 18 new customers this quarter, confirming the continued interest in our products.

By contrast, legacy product and service revenue experienced a rebound during the quarter, increasing from 12.7 million in the second quarter of 2006 to 15.1 million in this quarter. Sales of our legacy products rebounded from the prior quarter and experienced a sequential growth of 18.8%.

Most of this increase resulted from orders that were delayed from the second quarter, rather than as a result of a new growth trend. As we've said in the past, we expect our legacy businesses to decline by 5 to 10% year-over-year. That overall decline will likely be somewhat uneven going forward, as that part of our business becomes smaller and therefore more concentrated. With the concentration, legacy product revenue will fluctuate with the buying patterns of fewer customers.

Meanwhile, Optical Transport revenue continued to fluctuate and was 4.4 million this quarter, down from 6.3 million in the previous quarter. In the long term, we expect our Optical Transport business to grow, but quarter-to-quarter fluctuations like this past quarter should be expected due to our significant customer concentration in this business as well. Overall, we had one 10% customer during the quarter due to the reduction in our overall revenue.

On a year-to-date basis, we continued to have no customers comprising more than 10% of our revenues. Our top five customers represented approximately 33% of our quarterly revenue as compared to just 26% in the second quarter. On a year-to-date basis, our top five customers represented approximately 26% of total revenues. We continued to enjoy a diversified customer base with approximately 600 active customers.

International revenue was approximately 37% of total revenue in the third quarter of 2006, as compared to 45% in the second quarter. This decline in international revenue as a percentage of total revenue during the current quarter follows six consecutive quarterly increases. On a year-to-date basis, our total international revenue was approximately 41% of total revenue as compared to 32% for the nine months ended September 30, 2005. For the third quarter of 2006, our SLMS revenue represented 55% of our business, which is down from 65% in the second quarter.

At the same time, our legacy and service revenue increased to 35% of our business, from 23% in the second quarter. We do not believe the shift is indicative of a new trend. Instead, it merely represents the shortfall in international SLMS revenue and a temporary spike in legacy and service revenue. Going forward we expect our SLMS business to overtake the legacy business as the legacy customers migrate to our next generation solution. Overall, we expect total revenues to rebound to between 43 and 45 million for the fourth quarter of 2006.

Now, let's turn to gross margins. Gross margins were 35% for the third quarter of 2006, which was within the 35 to 36% range of revised guidance we previously provided. Margins increased [over the par for] largely because we wrote off 7.2 million of our legacy inventory during the second quarter. Going forward, we expect full benefit of outsourcing to CTDI, as well as increased revenue leverage to help improve our gross margins to between 35 to 37% in the fourth quarter.

As for operating expenses, we incurred a non-cash charge for impairment of our goodwill and intangible assets of 113.7 million. Total operating expenses, excluding this impairment charge for the third quarter of 2006, were 22.6 million, which was at the low end of our forecasted range of between 22.5 and 24.5 million. Operating expenses included depreciation of approximately 0.5 million, amortization of 0.3 million, and stock-based compensation of 1.1 million. Overall, OpEx without regard to the impairment charge decreased by 2.1 million as compared to operating expenses for the second quarter which were 24.7 million. This decrease in expenses was primarily attributable to non-recurring specific new product development efforts incurred during the second quarter.

Unfortunately, those efforts for the potential major customer did not result in a win for Zhone. Going forward, we anticipate total operating expenses for the fourth quarter of 2006 to drop approximately 5 to 10% to between 20.5 and 22.5 million, as we streamline our operations. Our expense guidance includes approximately 1.5 million of expenses for depreciation and stock-based compensation. Finally, pro forma EBITDA for the third quarter was a loss of 5.1 million and below the anticipated range of roughly breakeven due to the previously mentioned revenue shortfall. Our estimated pro forma EBITDA for the fourth quarter is a loss between 2 to 5 million. Nonetheless, our goal is to achieve pro forma positive EBITDA as soon as possible.

Turning to the balance sheet, our cash and short term investments at September 30, 2006, were 65.8 million which is down from 71.8 million at June 30, 2006. Cash balances declined during the quarter, primarily as a result of the unexpected pro forma EBITDA loss of 5.1 million, and an anticipated debt prepayment of 1.5 million. Thus, our total debt obligations decreased by 1.5 million from 43.1 million at June 30, 2006, to 41.6 million at September 30, 2006 as a result of this prepayment. On a combined basis, our net cash balance, or cash net of debt obligations, decreased by a total of approximately 4.5 million during the quarter. The decrease in net cash follows three consecutive quarters of positive net cash generation. As mentioned, we expect to grow revenues, improve margins, and reduce our operating expenses. The combined effect of these efforts will minimize net cash burn for next quarter.

As for the balance sheet changes, accounts receivable levels decreased as a result of decreased revenues. Despite this drop in accounts receivable, the number of days sales outstanding on accounts receivable increased to 74 days for Q3, 2006, as compared to 65 days for Q2, 2006, primarily as a result of increased receivables from international customers. Inventory levels increased from 47.5 million at June 30, 2006, to 48.4 million at September 30, 2006, as a result of delays in customer orders. We expect those orders to be fulfilled during the fourth quarter and inventory levels to decline accordingly. Finally the average basic and diluted EPS shares were 148.8 million for the third quarter.

Before I turn the call back to Mory, let me summarize the financial results for the third quarter and recap our guidance for next quarter. Declines in our international and SLMS revenue, caused primarily by technology transitions and order deferrals, resulted in the shortfall in overall revenue even though legacy revenue rebounded during the quarter. Following our disappointing third quarter, we have revised our estimates and expect the fourth quarter revenue levels to rebound slightly to between 43 and 45 million.

As for other financial metrics for the fourth quarter of 2006, we expect gross margins to improve to between 35 and 37% and operating expenses to decline to between 20.5 and 22.5 million, including 1.5 million of expenses for depreciation and stock-based compensation. Overall, we hope to substantially reduce our pro forma EBITDA loss and negative cash through our efforts to grow revenues, improve gross margins, and reduce operating expenses.

With that overview, I'll turn the call back to Mory.

Thank you, Kirk.

Although we are disappointed with the short-term financial results for the third quarter, we are encouraged by the continued customer wins and therefore expect our revenues to rebound over the next few quarters. We have taken the opportunity to streamline our operations and expect to see increases in our gross margin as well as reduction in operating expenses. As I mentioned at the beginning of the call, our primary goal is to achieve quarterly profitability by the end of 2007.

We are fully engaged in the business of this Company and absolutely believe in the long-term strategy and vision for the Company. We are confident that we have the right strategy, the right solution, and the right [inaudible] to take advantage of the tremendous opportunities that lies ahead. We appreciate your continued support in that effort.

Thank you for joining us today. Now I would like to open the call to the questions. Operator, please begin the Q&A portion of the call.

[OPERATOR INSTRUCTIONS].

Operator, if there's no questions we are going to discontinue the call.

There are currently no questions in queue.

Okay. Well, thank you again for joining us today. We appreciate your support and looking forward to speaking with you in our next conference call. Thank you. Operator?

Thank you for attending today's conference. This concludes the presentation. You may now disconnect. Good day.